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Asset allocation and portfolio diversifications are words often bandied about by investment advisors and financial planners. But what exactly does it mean for the ordinary investor, and why do you need it? Simply put, asset allocation is how you distribute your investments among the different types of investment vehicles such as stocks, bonds, and mutual funds. And portfolio diversification is taking asset allocation one step further by mapping out further diversity within a specific asset class, such as investing in both U.S. stocks and emerging market stocks.
It will help minimize the risk of too much exposure to one asset class or product. Every sector has problems periodically. For example, the current real estate and the financial crisis have not significantly affected the general economy or overseas markets. Thus, an investor with a diversified portfolio with REITs, company stocks, U.S. bonds, and emerging market investments would likely have a cushion and a safety net.
Moving on to asset allocation strategies for qualified retirement plans like a 401(k), what are the options, and what is the best way to ensure sufficient diversity of financial products without sacrificing performance?
The first thing to consider is your needs and the costs to fulfill them after retirement. Once you have a ballpark needs figure compared with resources on hand, you can determine what kind of return rates you need. Once you have a return rate, you need to work out a mix of asset classes that will provide you with this return rate. The trick here is to include as much of a safe asset class, such as bonds, as possible. Start the calculations from the lower end, where you get less than what you need but with reduced risk. Increase the risky asset classes in small increments while lowering the safe ones until you end up at the correct rate of return after adding up the returns from all asset classes.
A general rule is the further away from retirement you are, the more risks you can afford to take. As you move closer to retirement, moving more and more assets into safer areas is better. Thus, for people aged 50 or below, an aggressive combination of 80% private equity, alternative investments, and growth stocks is recommended, while for those close to retirement, a majority of the total investment should be in a safe class such as U.S. Treasury Bonds.
This may sound a bit complicated, but more natural ways, such as charts, tools, and calculators, can help you perform 401(k) asset allocations. Please note that employers have the right to offer or decline specific asset classes and sub-accounts to employee 401(k) plans. You are advised to consult your company's plan advisor or manager and study the historical performance data for the plan as a whole.
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